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Weathering the "Other-Than-Temporary" Impairment Storm

Properly apply new FASB Staff Position EITF 99-20-1 to your investment securities.

By Thomas G. Rees and Kenneth F. Fick
March 2009

Weathering OTTI Storm

As if a recession, the credit crisis and the housing downturn were not causing enough stress, many companies, and their accountants and auditors, must also consider an accounting issue that has become increasingly pressing—should their investments be considered “other-than-temporarily impaired”? This issue is relevant not only for financial institutions but for any company that holds corporate debt, structured investment securities (CDOs, mortgage-backed and other asset-backed securities) or equities.

Some market analysts and members of the financial press have blamed U.S. GAAP’s fair value accounting requirements for exacerbating financial markets’ instability. Frequently, critics attribute the problem to the application of FASB Statement no. 157, Fair Value Measurements. However, Statement no.157 provides guidance on how to measure fair value, not when assets should be recorded at fair value.

The real controversy comes from accounting standards that require entities to measure certain assets or liabilities at fair value. During market downturns, the accounting requirements relating to recognition of impairment on investment securities become especially contentious. These rules require accountants to make subjective assessments in determining when impairment should be considered “other than temporary,” and if so, to write down the impaired asset to its fair value with a charge to current-period earnings. Companies are generally reluctant to take such impairment charges because once a new cost basis is established from the write-down, any subsequent appreciation in fair value of the impaired security may not be recognized until the security is sold. At the same time, the decision not to recognize impairment is subject to close scrutiny by analysts and regulators.

This article discusses current accounting requirements relating to the assessment of impairment of equity securities with readily determinable fair values and all debt securities, including the effects of the recently issued FASB Staff Position no. EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. It also summarizes the disclosure requirements for securities that have fair values below recorded cost. While there are no “bright lines” for making the impairment determination, this article summarizes the authoritative accounting guidance and reiterates some of the previously stated SEC staff views on the matter. In addition, this article provides some practical considerations that may help entities avoid unwanted scrutiny about their impairment decisions.

MORE CHANGE IN THE WIND
FASB recently added a project to its agenda, titled “Recoveries of Other-Than-Temporary Impairments (Reversals),” which could significantly affect accounting for impairment on securities. In a related project, the FASB recently issued FSP FAS 107-a, Disclosures about Certain Financial Assets, to increase the comparability of certain financial instruments that have similar economic characteristics but different measurement attributes. All of these efforts reflect FASB’s effort to improve the accounting and reporting for financial instruments while moving toward convergence with IFRS.

CATEGORIES OF INVESTMENT SECURITIES
FASB Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities, is the authoritative accounting guidance for investments in debt and equity securities with readily determinable fair values. Statement no. 115 requires entities to classify investment securities into one of three categories upon acquisition:

Held-to-maturity (HTM)

Trading

Available-for-sale (AFS)


In addition to defining the three classifications of securities, Statement no. 115 requires entities to assess their AFS and HTM securities each reporting period to determine whether declines in fair value below book value are to be considered other than temporary. Trading securities are marked to fair value each reporting period and are not subject to ongoing impairment analyses since their unrealized losses (if any) have already been included in earnings.

If impairment is considered other than temporary, the holder must write down the cost basis of the impaired security to fair value. The amount of the write-down is included in earnings as a realized loss, and a new cost basis is established for the security. Any subsequent recovery in fair value is not recognized in earnings until the security is sold.

PROCESS FOR ASSESSING IMPAIRMENT
Two accounting models are used to assess impairment on securities, and until recently, they were very distinct. One model is defined in Emerging Issues Task Force Issue no. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, and applies to credit-sensitive mortgage and other asset-backed securities and certain prepayment-sensitive securities. For all other securities, except investments accounted for under the “equity” method, entities follow the approach in paragraph 16 of Statement no. 115 that is further explained in FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.

THE FASB 115 MODEL
FAS 115 and its amendments provide a three-step process for determining whether impairment should be considered other than temporary.

1. Determine whether the investment is impaired. An investment is impaired if its fair value is less than its amortized cost basis (book value). The cost basis of an investment includes adjustments made for accretion, amortization, other impairments and hedging. Entities should make this assessment at the individual security level each reporting period. (FSP FAS 115-1 also discusses how to assess impairment on “cost method investments.” The steps for assessing impairment are essentially the same as for marketable equity securities and debt instruments, but because the fair value of cost method investments may not be readily available, FSP FAS 115-1 describes a different approach for obtaining fair value and the related disclosures.)

2. Evaluate whether the impairment is other than temporary. Entities must evaluate impairment based on specific factors including the nature and extent of the decrease in fair value of the security below cost. This is a subjective assessment that is discussed in more detail below.

3. If the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value.The amount of the write-down is the difference between amortized cost and the fair value of the investment on the balance sheet date. When impairment is recognized, the fair value of the impaired security becomes the new cost basis of the investment, and subsequent recoveries in fair value are not recognized in earnings until the security is sold or matures.

THE REVISED EITF 99-20 MODEL
The previous EITF 99-20 model was more stringent than the Statement no. 115 model because it was triggered by any adverse change in the estimated timing or amount of cash flows that “market participants” would use as opposed to the more subjective assessment of whether impairment is other than temporary. The application of this model resulted in outcomes that some practitioners considered inappropriate because it did not permit management to consider the probability that all previously projected cash flows would be collected. For example, recently, there has not been an active market for CDOs and certain other structured mortgage securities. While most cash flow models indicate there have been adverse changes in the projected cash flows of these securities, the present value of those cash flows may be significantly higher than the observed fair value of the security in an illiquid market. In these situations, some practitioners believe that application of the EITF 99-20 model resulted in recognition of an impairment loss that would not have been required for similar securities under the FAS 115 approach.

On Jan. 12, 2009, FASB issued FSP EITF 99-20-1 to more closely align the EITF 99-20 impairment model with that of Statement 115 and its implementation guidance. By eliminating the key distinctions between the two models, the amendment results in more consistent criteria for determining whether an other-than-temporary impairment has occurred for all securities. Specifically, FSP EITF 99-20-1 replaces the requirement to use market participant assumptions when determining future cash flows and instead, requires an assessment of whether it is probable that there has been an adverse change in estimated cash flows (see Exhibit 1).

DISCLOSURE REQUIREMENTS
An important aspect of an entity’s accounting for securities is the disclosures it makes about securities that are “underwater” (securities whose fair value is less than book value). Specifically, FSP FAS 115-1 requires entities to disclose the amounts of unrealized losses and the aggregated fair value of investments with unrealized losses. These disclosures should be segregated into two buckets—those investments that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 months or longer. The reference point for determining how long an investment has been in a continuous unrealized loss position is the balance sheet date of the reporting period in which the impairment is initially identified. Exhibit 2 provides an example of the required disclosure.

Entities must disclose additional information (in narrative form) in the notes to the financial statement to provide insight into the company’s rationale for reaching the conclusion that existing impairment(s) is temporary. Such additional information may include:

(1) The nature of the investment(s).

(2) The cause(s) of the impairment(s).

(3) The number of investment positions that are in an unrealized loss position.

(4) The severity and duration of the impairment(s).

(5) Other evidence considered in reaching its conclusion that the investment is not other-than-temporarily impaired.

In addition, the SEC staff noted in its Nov. 30, 2006, Current Accounting and Disclosure Issues in the Division of Corporation Finance (Nov. 30, 2006 SEC Guidance), that a recognized or potential other-than-temporary impairment may require discussion in the management’s discussion and analysis (MD&A) section of SEC filings if the amount of loss or potential loss is material, or in certain other circumstances, where discussion would be necessary to provide the reader with an understanding of financial condition or results of operations.

Arguably, the focus of these disclosure requirements suggest a presumption that securities that are underwater for an extended period of time should generally be considered other-than-temporarily impaired unless there is a reasonable justification for concluding that the recorded value will ultimately be realized. The disclosure requirements suggest an important threshold is 12 months, but in practice many companies have securities that have been underwater for 18 to 24 months and do not consider them to be other-than-temporarily impaired.

EVALUATING “OTHER-THAN-TEMPORARY” IMPAIRMENT
In its discussion about impairment, paragraph 16 of Statement no. 115 indicates: “For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment should be considered to have occurred.” In making the assessment, the holder must consider all available evidence, including the issuer’s financial condition and near-term prospects, the severity and duration of the decline in fair value, and the investor’s intent and ability to hold the investment for a reasonable period of time sufficient for a forecasted recovery.

The SEC staff indicated in its Nov. 30, 2006, guidance and previous guidance that it is inappropriate to apply “bright line” or “rule of thumb” tests in making the assessment, so accountants must use judgment. Because the decision about whether the decline in fair value of a security is other-than-temporary is subjective, it often is included as a critical accounting assumption in the notes to the financial statements, particularly for companies with significant investment portfolios.

Even though FSP FAS 115-1 is the definitive accounting guidance on the meaning of other-than-temporary impairment, it refers to other accounting literature for guidance in evaluating impairment. Similarly, both Statement no. 115, and the FASB staff implementation guidance relating to Statement no. 115 refer to SEC Staff Accounting Bulletin (SAB) no. 59, codified as SAB Topic 5.M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities (SAB 59), and Statement on Auditing Standards no. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities (SAS no. 92), for guidance.

In addition to the factors mentioned above, SAB 59 and SAS no. 92 identify several factors that indicate other-than-temporary impairment of a security’s value has occurred. These factors should be evaluated both individually and collectively and include:

The length of time and extent to which the market value has been less than cost.

The financial condition and near-term prospects of the issuer, including specific events which may affect the issuer’s operations or future earnings. Examples include changes in technology or the discontinuance of a segment of the business.

The intent and ability of the holder to retain its investment in the issuer for a period sufficient to allow for any anticipated recovery in market value.

Whether a decline in fair value is attributable to adverse conditions specifically related to the security or specific conditions in an industry or geographic area.

The investee’s credit rating and whether the security has been downgraded by a rating agency.

Whether dividends have been reduced or eliminated, or scheduled interest payments have not been made.

The cash position of the investee.

FSP EITF 99-20-1 provided additional guidance, reminding entities to consider all available information relevant to the collectibility of the security, including “information about past events, current conditions, and reasonable and supportable forecasts,” when developing estimates of future cash flows.

Reporting entities should evaluate these factors, placing greater weight on evidence that is objective and verifiable than subjective assessments. While there are no bright lines in making such assessments, there are situations where the conclusion that an impairment is other than temporary is relatively straightforward. For example, if the issuer of a corporate debt instrument defaults on scheduled interest or principal payments, there is strong evidence that the debt is other-than-temporarily impaired. In addition, based on SAB 59, if the investor does not have the intent or ability to hold an impaired security for a sufficient period of time to recover the recorded amount of the investment, an other-thantemporary impairment must be recognized. Accordingly, even if an unrealized loss is not severe, or has been of short duration, an impairment charge should be recorded if the investor does not plan or is unable to hold the security long enough to realize the recorded amount.

Because equity securities do not have contractual cash flows, they are evaluated differently than debt securities. The ability to hold an equity security indefinitely is not, by itself, a sufficient basis for the holder to conclude that an impairment charge is not necessary.

The federal government’s recent imposition of conservatorship on Fannie Mae and Freddie Mac provides an example of other-than-temporary impairment of an equity investment. As part of the takeover, the federal government received warrants enabling the government to buy up to 79.9% of the common stock of those entities for $0.00001 per share. In addition, the dividends on Fannie Mae and Freddie Mac common stock were eliminated. Both of these conditions (extensive dilution of shareholder value through issuance of shares below the current market price and elimination of the dividend) provide objective evidence that impairment is otherthan- temporary. Accordingly, most entities that held Fannie Mae or Freddie Mac common stock recognized impairment charges in financial statements in the periods immediately after the conservatorship was announced.

In limited circumstances, the SEC has provided guidance related to specific types of securities. For example, in October 2008 the SEC provided guidance on perpetual preferred securities (preferred stock that has “debt-like” characteristics such as regular dividends, call features, debt-like credit ratings and are priced like other long-term callable bonds) allowing entities to account for such equities as debt in certain limited circumstances.

The SEC indicated that an entity may avoid recognizing an other-than-temporary impairment for these types of securities by asserting that it has the intent and ability to continue holding the security for a sufficient period to allow for an anticipated recovery in market value as long as the decline in fair value is not attributable to the credit deterioration of the issuer. This guidance should be applied with the same rigor as the evaluation of all other debt or equity securities held by a company in order to ensure the application of substance over form.

PRACTICAL CONSIDERATIONS
Because assessing impairment requires estimating the outcome of future events, accountants making such decisions may be subject to second-guessing. A company’s policy regarding recognition of impairment on investment securities is often considered a critical accounting estimate and is disclosed as such in the MD&A section of SEC filings.

Given the judgment required in this area, auditors and the SEC focus on management’s reasoning for their impairment decisions when reviewing companies’ filings. Because of its importance, the SEC staff has frequently addressed this issue in communications with the industry.

For example, in the Nov. 30, 2006, guidance, the SEC staff states that, “the Commission expects registrants to employ a systematic methodology that includes documentation of the factors considered.” Accordingly, companies should have a formal approach requiring that all available information be considered when assessing impairment. The approach should place greater weight on objective evidence as opposed to subjective factors. Entities must apply that approach consistently and document the factors considered in reaching their conclusions. For example, assumptions regarding macroeconomic conditions or entity-specific factors or events that were considered in assessing the issuers’ operations and future earnings should be specifically documented.

To avoid unwanted scrutiny, entities are encouraged to adopt a formal accounting policy requiring:

Evaluation of impairment on a quarterly basis.

Consistent application of a systematic and rational methodology.

Identification of the factors to be considered in completing the analysis.

Documentation of the factors considered and the basis for the conclusions reached for each security evaluated.

In addition, entities may be able to reduce investor and counterparty concerns about unrecognized impairment by providing detailed disclosures about their investments.

At the annual AICPA National Conference on Current SEC and PCAOB Developments held in December 2008, SEC staff members provided suggestions about the type of detailed disclosures entities should consider, including:

Separate identification of other-than-temporary impairments caused by credit-related issues from those caused by other factors, such as the absence of an ability or intent to hold a security to maturity.

The nature of collateral underlying structured securities, including the types of assets, year of origination, their credit ratings and credit enhancements.

Information about how illiquidity was considered in determining the amount of impairment, including the specific assumptions used, their rationale, and how they evolved as a result of market conditions.

Such information, if provided with appropriate context, may help ease the market’s uncertainty regarding management’s estimates.

CONCLUSION
The accounting rules for evaluating impairment on investment securities are subjective and require considerable judgment. Impairment decisions are particularly controversial in times of economic downturns and market stress, much like the current environment. While there are no bright lines for making impairment decisions, there are situations where the need to recognize impairment is obvious. Absent these situations, judgment is required and entities making those judgments will be subject to scrutiny from investors, counterparties and regulatory authorities.

Companies may be able to reduce investor and counterparty concerns about unrecognized impairment by having formal policies that are applied consistently, documentation that summarizes the factors considered and the basis for the conclusions reached, and meaningful disclosures that enable market participants to assess an entity’s rationale for concluding that the recorded value of the securities will ultimately be realized.

Web-Exclusive Sidebars:
Securities Covered by EITF 99-20
IFRS Requirements for Recognizing Impairment on Securities


 

EXECUTIVE SUMMARY

 Accounting guidance requires entities to categorize an investment security into one of three categories upon acquisition: held to maturity (“HTM”), trading, or available for sale (“AFS”). In addition to defining the three classifications of securities, an entity is required to assess both the classification of AFS and HTM securities each reporting period and to determine whether any declines in fair value below amortized cost should be considered other than temporary.

 There are two primary accounting models for assessing impairment on securities. EITF 99-20 applies to all credit-sensitive mortgage- and asset-backed securities and certain prepayment- sensitive securities and FAS 115 applies to all other securities, except investments accounted for under the equity-method. Subsequent to the issuance of FSP EITF 99-20-1, the models are essentially the same.

 Companies must disclose, (in tabular format) the amount of unrealized losses and the aggregated fair value of investments with unrealized losses in investment securities whose fair value is less than book value and for which an other-than-temporary impairment charge has not been taken. Additional narrative disclosure is required to provide insight into an entity’s rationale for concluding that existing impairment(s) is temporary.

 Entities should consider all available evidence in determining whether an other-thantemporary charge should be recognized. Greater weight should be placed on evidence that is objective and verifiable than subjective assumptions. The application of a “bright line” or “rule of thumb” test is not appropriate.

 Entities should employ a systematic methodology that is applied consistently and includes formal documentation of the factors considered when assessing impairment.

Thomas G. Rees, CPA, CFA, CFE, is a managing director and Kenneth F. Fick, CPA/ABV, is a director in the forensic and litigation practice of FTI Consulting Inc. Their e-mail addresses, respectively, are thomas.rees@fticonsulting.com and ken.fick@fticonsulting.com.

The views expressed in the article are the authors’ and are not necessarily representative of FTI Consulting Inc.


 

AICPA RESOURCES

JofA articles
Fair Value Roundtable,” June 08, page 60
The Role of Fair Value Accounting in the Subprime Mortgage Meltdown,” May 08, page 34
Securitized Profits,” May 08, page 54
Refining Fair Value Measurement,” Nov. 07, page 30

Publication
Current Economic Crisis—Accounting and Auditing Considerations (#0223308)

For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077.

On-Site Training
FASB Review for Industry (Acronym #FASBI)

To access on-site training courses, go to www.aicpalearning.org, click “On-Site Training” and search by “Acronym Index.” If you need assistance, please contact a training representative at 800-634-6780 (option 1).

Business, Industry & Government
For more information and resources for members in business, industry and government, visit the Financial Management Center at www.aicpa.org/fmcenter.

OTHER RESOURCES

Current Accounting Guidance
FASB Statement no. 157, Fair Value Measurements

FASB Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities

Staff Accounting Bulletin (SAB) no. 59, codified as SAB Topic 5.M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities

Emerging Issues Task Force Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets

FASB Staff Position EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20

Financial Staff Position FAS 115-1 and FAS 124-1, The Meaning of Other-Than- Temporary Impairment and Its Application to Certain Investments

FASB Statement no. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a replacement of FASB Statement No. 125

(AICPA) Statement on Auditing Standards no. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities

SEC staff’s Nov. 30, 2006 update on Current Accounting and Disclosure Issues in the Division of Corporation Finance

International Accounting Standard 39, Financial Instruments: Recognition and Measurement

Publication
Valuation for Financial Reporting: Fair Value Measurements and Reporting, Intangible Assets, Goodwill and Impairment, 2nd Edition, by Michael J. Mard, James R. Hitchner and Stephen D. Hyden, John Wiley & Sons Inc., 2007

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